Archive for July, 2012

An earthquake of second quarter earnings results have rocked the markets (better than expected earnings but sluggish revenues), and now investors are left to sift through the rubble. With thousands of these earnings reports rolling in (and many more in the coming weeks), identifying the key investment trends across sectors, industries, and geographies can be a challenging responsibility. If this was an easy duty, I wouldn’t have a job! Fortunately, having a disciplined process to sort through the avalanche of quarterly results can assist you in discovering both potential threats and opportunities.

But first things first: You will need some type of reliable screening tool in order to filter find exceptional stocks. According to Reuters, there are currently more than 46,000 stocks in existence globally. Manually going through this universe one stock at a time is not physically or mentally feasible for any human to accomplish, over any reasonable amount of time. I use several paid-service screening tools, but there are plenty of adequate free services available online as well.

Investing with the 2-Sided Coin

As Warren Buffett says, “Value and growth are two sides of the same coin.” Having a disciplined screening process in place is the first step in finding those companies that reflect the optimal mix between growth and value. I am willing to pay an elevated price (i.e., higher P/E ratio) for a company with a superior growth profile, but I want a more attractive value (i.e., cheaper price) for slower growth companies. I am fairly agnostic between the mix of the growth/value weighting dynamics, as long as the risk-reward ratio is in my favor.

Since I firmly believe that stock prices follow the long-term trajectory of earnings and cash flows, I fully understand the outsized appreciation opportunities that can arise from the “earnings elite” – the cream of the crop companies that are able to sustain abnormally high earnings growth. Or put in baseball terms, you can realize plenty of singles and doubles by finding attractively priced growth companies, but as Hall of Fame manager Earl Weaver says, “You win many more games by hitting a three-run homer than you do with sacrifice bunts.” The same principles apply in stock picking. Legendary growth investor Peter Lynch (see also Inside the Brain of an Investing Genius) is famous for saying, “You don’t need a lot of good hits every day. All you need is two to three goods stocks a decade.”

Some past successful Sidoxia Capital Management examples that highlight the tradeoff between growth and value include Wal-Mart stores (WMT) and Amazon.com (AMZN). Significant returns can be achieved from slower, mature growth companies like Wal-Mart if purchased at the right prices, but multi-bagger home-run returns (i.e., more than doubling) require high octane growth from the likes of global internet platform companies. Multi-bagger returns from companies like Amazon, Apple Inc. (AAPL), and others are difficult to find and hold in a portfolio for years, but if you can find a few, these winners can cure a lot of your underperforming sins.

Defining Growth

Fancy software may allow you to isolate those companies registering superior growth in sales, earnings, and cash flows, but finding the fastest growing companies can be the most straightforward part. The analytical heavy-lifting goes into effect once an investor is forced to determine how sustainable that growth actually is, while simultaneously determining which valuation metrics are most appropriate in determining fair value. Some companies will experience short-term bursts of growth from a single large contract; from acquisitions; and/or from one-time asset sale gains. Generally speaking, this type of growth is less valuable than growth achieved by innovative products, service, and marketing.

The sustainability of growth will also be shaped by the type of industry a company operates in along with the level of financial leverage carried. For instance, in certain volatile, cyclical industries, sequential growth (e.g. the change in results over the last three months) is the more relevant metric. However for most companies that I screen, I am looking to spot the unique companies that are growing at the healthiest clip on a year-over-year basis. These recent three month results are weighed against the comparable numbers a year ago. This approach to analyzing growth removes seasonality from the equation and helps identify those unique companies capable of growing irrespective of economic cycles.

Given that we are a little more than half way through Q2 earnings results, there is still plenty of time to find those companies reporting upside fundamental earnings surprises, while also locating those quality companies unfairly punished for transitory events. Now’s the time to sift through the earnings rubble to find the remaining buried stock gems.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and WMT, AMZN, AAPL, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

In the wild, there exist both parasitic and symbiotic relationships. In the case of blood thirsty ticks that feed off deer, this parasitic relationship differs from the symbiotic association of nectar-sucking bees and pollen-hungry flowers. These are merely a few examples, but suffice it to say, these same intricate interactions occur in the business world as well.

Our economy is a complex jungle of relationships, spanning governments, businesses, consumers, investors, and many intermediaries, including private equity (PE) firms. With the November election rapidly approaching, more attention is being placed on how private equity firms fit into the economic food chain. Figuring out whether PE firms are more like profit-sucking parasites or constructive job creating mechanisms has moved to the forefront, especially given presidential candidate Mitt Romney’s past ties to Bain Capital, a successful private equity firm he founded in 1984.

Currently it is politically advantageous to portray PE professionals as greedy, job-cutting outsourcers – I’m still waiting for the political ad showing a PE worker clubbing a baby seal or plucking the legs off of a Daddy Long Legs spider. While I’d freely admit a PE pro can be just as gluttonous as an investment banker, hedge fund manager, or venture capitalist, simplistic characterizations like these miss the beneficial effects these firms provide to the overall economy. Capitalism is the spine that holds our economy together and has allowed us to grow into the greatest superpower on the planet. Private equity is but a small part of our capitalistic ecosystem, but plays a valuable role nonetheless.

While there are many perspectives on the role of private equity in our economy, here are my views on a few of the hot button issues:

Job Creation: Although I believe PE firms are valuable to our economy, I think it is a little disingenuous of Romney and his supporters to say Bain was a net “job creator” to the tune of 100,000+ jobs during his tenure. The fact of the matter is PE firms’ priority is to create profitable returns for its investors, and if that requires axing heads, then so be it – most PE firms have no qualms doing precisely that. Romney et al point to successes like Staples Inc. (SPLS), Dominos Pizza Inc. (DPZ) and Sports Authority, Inc., where profitability and success ultimately led to job expansion. From my viewpoint, I believe these examples are more the exception than the rule. Not surprisingly, any job losses executed in the early years of a PE deal will eventually require job additions if the company survives and thrives. Let’s face it, no company can cut its way to prosperity in perpetuity.

Competitveness: Weak, deteriorating, or bankrupt companies cannot and will not hire. Frail or mismanaged companies will sooner or later be forced to cut jobs on their own –the same protocol applied by opportunistic PE vultures swarming around. While PE firms typically focus on bloated or ineffective companies, I think the media outlets overemphasize the cost-cutting aspects of these deals. Sure, PE companies cut jobs, outsource functions, and cut benefits in the name of profits, but that alone is not a sustainable strategy. Trimming fat, by replacing complacent management teams, investing in modern software/equipment, expanding markets, and implementing accountability are all paramount factors in making these target companies more efficient and competitive in the long-run.

Financial Markets-Arbiter: At the end of the day, I think the IPO/financial markets are the final arbiters of how much value PE firms create, not only for investors, but also for the economy overall. If greedy PE firms’ sole functions were to saddle companies with massive debts, cut heads off, and then pay themselves enormous dividends, then there would never be a credible exit strategy for investors to cash out. If PE firms are correctly performing their jobs, then they will profitably create leaner more efficient durable companies that will be able to grow earnings and create jobs over the long-term. If they are unsuccessful in this broad goal, then the PE firm will never be able to profitably exit their investment via a corporate sale or public offering.

Bain Banter: Whether you agree with PE business practices or not, it is difficult to argue with the financial success of Bain Capital. According to a Wall Street Journal article, Bain Capital deals between 1984 – 1999 produced the following results:

“Bain produced about $2.5 billion in gains for its investors in the 77 deals, on about $1.1 billion invested. Overall, Bain recorded roughly 50% to 80% annual gains in this period, which experts said was among the best track records for buyout firms in that era.”

Critics are quick to point out the profits sucked up by PE firms, but they neglect to acknowledge the financial benefits that accrue to the large number of pension fund, charity, and university investors. Millions of middle-class American workers, retirees, community members, teachers, and students are participating in those same blood sucking profits that PE executives are slurping down.

Even though I believe private equity is a net-positive contributor to competiveness and economic growth in recent decades, there is no question in my mind that these firms participated in a massive bubble in the 2005-2007 timeframe. Capital was so cheap and abundant, prices on these deals escalated through the roof. What’s more, the excessive amounts of leverage used in those transactions set these deals up for imminent failure. PE firms and their investors have lost their shirts on many of those deals, and the typical 20%+ historical returns earned by this asset class have become long lost memories. Attractive returns do not come without risk.

With the presidential election rhetoric heating up, the media will continue to politicize, demonize and oversimplify the challenges surrounding this asset class. Despite its shortcomings, private equity will continue to have a positive symbiotic relationship with the economy…rather than a parasitic one.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in SPLS, DPZ, Sports authority, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

Paul Meehl was a versatile academic who held numerous faculty positions, covering the diverse disciplines of psychology, law, psychiatry, neurology, and yes, even philosophy. The crux of his research was focused on how well clinical analysis fared versus statistical analysis. Or in other words, he looked to answer the controversial question, “What is a better predictor of outcomes, a brain or an equation?” His conclusion was straightforward – mechanical methods using quantitative measures are much more efficient than the professional judgments of humans in coming to more accurate predictions.

Those who have read my book, How I Managed $20,000,000,000.00 by Age 32 know where I stand on this topic – I firmly believe successful investing requires a healthy balance between both art and science (i.e., “brain and equation”). A trader who only relies on intuition and his gut to make all of his/her decisions is likely to fall on their face. On the other hand, a quantitative engineer’s sole dependence on a robotic multi-factor model to make trades is likely to fail too. My skepticism is adequately outlined in my Butter in Bangladesh article, which describes how irrational statistical games can be misleading and overused.

As much as I would like to attribute all of my investment success to my brain, the emotion-controlling power of numbers has played an important role in my investment accomplishments as well. The power of numbers simply cannot be ignored. More than 50 years after Paul Meehl’s seminal research was published, about two hundred studies comparing brain power versus statistical power have shown that machines beat brains in predictive accuracy in the majority of cases. Even when expert judgments have won over formulas, human consistency and reliability have muddied the accuracy of predictions.

Daniel Kahneman, a Nobel Prize winner in Economics, highlights another important decision making researcher, Robyn Dawes. What Dawes discovers in her research is that the fancy and complex multiple regression methods used in conventional software adds little to no value in the predictive decision-making process. Kahneman describes Dawes’s findings more specifically here:

“A formula that combines these predictors with equal weights is likely to be just as accurate in predicting new cases as the multiple-regression formula…Formulas that assign equal weights to all the predictors are often superior, because they are not affected by accidents of sampling…It is possible to develop useful algorithms without any prior statistical research. Simple equally weighted formulas based on existing statistics or on common sense are often very good predictors of significant outcomes.”

The results of Dawes’s classic research have significant application to the field of stock picking. As a matter of fact, this type of research has had a significant impact on Sidoxia’s stock selection process.

How Sweet It Is!

In the emotional roller-coaster equity markets we’ve experienced over the last decade or two, overreliance on gut-driven sentiments in the investment process has left masses of casualties in the wake of losses. If you doubt the destructive after-effects on investors’ psyches, then I urge you to check out my Fund Flow Paradoxarticle that shows the debilitating effects of volatility on investors’ behavior.

In order to more objectively exploit investment opportunities, the Sidoxia Capital Managementinvestment team has successfully formed and utilized our own proprietary quantitative tool. The results were so sweet, we decided to call it SHGR (pronounced “S-U-G-A-R”), or Sidoxia Holy Grail Ranking.

My close to two decades of experience at William O’Neil & Co., Nicholas Applegate, American Century Investments, and now Sidoxia Capital Management has allowed me to build a firm foundation of growth investing competency – however understanding growth alone is not sufficient to succeed. In fact, growth investing can be hazardous to your investment health if not kept properly in check with other key factors.

Here are some of the key factors in our Sidoxia SHGR ranking system:

Valuation:

Free cash flow yield

Price/earnings ratio

PEG ratio

Dividend yield

Quality:

Financials: Profit margin trends; balance sheet leverage

Management Team: Track record; capital stewardship

Market Share: Industry position; runway for growth

Contrarian Sentiment Indicators:

Analyst ratings

Short interest

Growth:

Earnings growth

Sales growth

Our proprietary SHGR ranking system not only allows us to prioritize our asset allocation on existing stock holdings, but it also serves as an efficient tool to screen new ideas for client portfolio additions. Most importantly, having a quantitative model like Sidoxia’s Holy Grail Ranking system allows investors to objectively implement a disciplined investment process, whether there is a presidential election, Fiscal Cliff, international fiscal crisis, slowing growth in China, and/or uncertain tax legislation. At Sidoxia we have managed to create a Holy Grail machine, but like other quantitative tools it cannot replace the artistic powers of the brain.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

Daniel Kahneman, a professor of psychology at Princeton University, knows a few things about human behavior and decision making, and he has a Nobel Prize in Economics to prove it. We live in a complex world and our brains will often try to compensate by using shortcuts (or what Kahneman calls “heuristics” and “biases”), in hopes of simplifying complicated situations and problems.

When our brains become lazy, or we are not informed in a certain area, people tend to also listen to so-called experts or pundits to clarify uncertainties. In the process of their work, Kahneman and other researchers have discovered something – experts should be listened to as much as monkeys. Frequent readers of Investing Caffeine understand my shared skepticism of the talking heads parading around on TV (read first entry of 10 Ways to Destroy Your Portfolio)

Here is how Kahneman describes the reliability of professional forecasts and predictions in his recently published bestseller, Thinking, Fast and Slow:

“People who spend their time, and earn their living, studying a particular topic produce poorer predictions than dart-throwing monkeys who would have distributed their choices evenly over the options.”

Most people fall prey to this illusion of predictability created by experts, or this idea that more knowledge equates to better predictions and forecasts. One of the factors perpetuating this myth is the rearview mirror. In other words, human’s ability to concoct a credible story of past events creates a false confidence in peoples’ ability to accurately predict the future.

Here’s how Kahneman describes the phenomenon:

“The idea that the future is unpredictable is undermined every day by the ease with which the past is explained…Our tendency to construct and believe coherent narratives of the past makes it difficult for us to accept the limits of our forecasting ability. Everything makes sense in hindsight, a fact financial pundits exploit every evening as they offer convincing accounts of the day’s events. And we cannot suppress the powerful intuition that what makes sense in hindsight today was predictable yesterday. The illusion that we understand the past fosters overconfidence in our ability to predict the future.”

Even when experts are wrong about their predictions, they tend to not accept accountability. Rather than take responsibility for a bad prediction, Philip Tetlock says the errors are often attributed to “bad timing” or an “unforeseeable event.” Philip Tetlock, a psychologist at the University of Pennsylvania did a landmark twenty-year study, which was published in his book Expert Political Judgment: How Good Is It? How Can We Know? (read excellent review in The New Yorker). In the study Tetlock interviewed 284 economic and political professionals and collected more than 80,000 predictions from them. The results? The experts did worse than blind guessing.

Based on the extensive training and knowledge of these experts, many of them develop a false sense of confidence in their predictions. Or as Tetlock explains it, “They [experts] are just human in the end. They are dazzled by their own brilliance and hate to be wrong. Experts are led astray not by what they believe, but by how they think.”

Brain Blunders and Stock Picking

The buyer of a stock thinks the price will go up and the seller of a stock thinks the price will go down. Both participants engage in the transaction because they believe the current stock price is wrong. The financial services industry is built largely on this phenomenon that Kahneman calls an “illusion of skill,” or ability to exploit inefficient market pricing. Relentless advertisements and marketing pitches continually make the case that professionals can outperform the markets, but this is what Kahneman found:

“Although professionals are able to extract a considerable amount of wealth from amateurs, few stock pickers, if any, have the skill needed to beat the market consistently, year after year. Professional investors, including fund managers, fail a basic test of skill: persistent achievement…Skill in evaluating the business prospects of a firm is not sufficient for successful stock trading, where the key question is whether the information about the firm is already incorporated in the price of its stock. Traders apparently lack the skill to answer this crucial question, but they appear ignorant of their ignorance.”

For the few managers that actually do outperform, Kahneman assigns luck to the outcome, not skill:

“For a large majority of fund managers, the selection of stocks is more like rolling dice than like playing poker. Typically at least two out of three mutual funds underperform the overall market in any given year…The successful funds in any given year are mostly lucky; they have a good roll of the dice.”

The picture for individual investors isn’t any prettier. Evidence from Terry Odeam, a finance professor at UC Berkeley, who studied 100,000 individual brokerage account statements and about 163,000 trades over a seven-year period, was not encouraging. He discovered that stocks sold actually did +3.2% better than the replacement stocks purchased. And this detrimental impact on performance excludes the significant expenses related to trading.

In response to Odean’s work, Kahneman states:

“It is clear that for the large majority of individual investors, taking a shower and doing nothing would have been a better policy than implementing the ideas that came to their minds….Many individual investors lose consistently by trading, an achievement that a dart-throwing chimp could not match.”

In a future Odean paper titled, “Trading is Hazardous to your Wealth,” Odean and his colleague Brad Barber also proved that “less is more.” The results showed the most active traders had the weakest performance, and those traders who traded the least had the best returns. Interestingly, women were shown to have better investment results than men.

Regardless of whether someone is listening to an expert, fund manager, or individual investor, what Daniel Kahneman has discovered in his long, illustrious career is that humans consistently make errors. If you are wise, you will heed Kahneman’s advice by stealing the expert’s darts and handing them over to the chimp.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

Article is an excerpt from previously released Sidoxia Capital Management’s complementary July 2012 newsletter. Subscribe on right side of page.

I love pizza, and most fellow connoisseurs have difficulty refusing a hot, fresh slice of heaven too. Pizza is so universally appreciated that people consider pizza like ice cream – it’s good even when it’s bad (I agree). However, even the biggest, diehard pizza-lover will sheepishly admit their fondness for the flat and circular cheesy delight changes when you integrate anchovies into the mix. Not many people enjoy salty, slimy, marine creatures layered onto their doughy mozzarella and marinara pizza paradise.

With all the turmoil and uncertainty going on in the global financial markets, prudently investing in a widely diversified portfolio, including a broad range of equity securities, is viewed as palatable as participating in an all-you-can-eat anchovy pizza contest. Why are investors’ appetites so salty now? Hmmm, let me think. Oh yes, here are a few things that come to mind:

Doesn’t sound too appealing, does it? So, what are most investors doing in this unclear market? Rather than feasting on a pungent pie of anchovies, investors are flocking to the perceived safety of low yielding asset classes, no matter the price. In other words, the short-term warmth and comfort of CDs, money market, checking, and fixed income assets are being gobbled up like nicotine-laced pepperoni pizzas selling for $29.95/each + tax. The anchovy alternative, like stocks, is much more attractively priced now. After accounting for dividends, earnings, and cash flows, the anchovy/stock option is currently offering a 2-for-1 special with breadsticks and a salad…quite the bargain!

Nonetheless, the plain and expensive pepperoni/bond option remains the choice du jour and there are no immediate signs of a pepperoni hangover just quite yet. However, this risk aversion addiction cannot last forever. The bond gorging buffet has gone on relatively unabated for the last three decades, as you can see from the chart below. In spite of this, the bond binging game is quickly approaching a mathematical terminal end-game, as interest rates cannot logically go below zero.

Source: Calafia Beach Pundit with Sidoxia comments

Since my firm (Sidoxia Capital Management) is based in Newport Beach, next to PIMCO’s global headquarters, we get to follow the progression of the bond binging game firsthand. I’ve personally learned that if I manage close to $2 trillion in assets under management, I too can construct a 23-story Taj Mahal-esque headquarters that overlooks the Pacific Ocean from a stones-throw away.

Beyond glorified headquarters, there is evidence of other low-risk appetite examples. Here are some reinforcing pictures:

The Bond Binge

Source (The Financial Times): Bond purchases have exploded in the last three years.

Cash Hoarding

Source (Calafia Beach Pundit): Stuffing money under the mattress has accelerated in recent years as fear, uncertainty, and doubt have reigned supreme.

The Anchovy Special

Even though anchovy pizza, or a broadly diversified portfolio across asset class, size, geography, and style may not sound appealing, there are plenty of reasons to fight the urges of caving to fear and skepticism. Here are a few:

1) Growth Rolls On: Despite the aforementioned challenges occurring domestically and abroad, growth has continued unabated for 11 consecutive quarters, albeit at a rate less than desired. We are not immune to global recessionary forces, but regardless of European forces, the U.S. has been resilient in its expansion.

Source: Calafia Beach Pundit

2) Jobs and Housing on the Upswing: Unemployment remains high, but our country has experienced 27 consecutive months of private creation, leading to more than 4 million new jobs being added to our workforce. As you can see from the clear longer-term downward trend in unemployment claims, we are moving in the right direction.

Source: Calafia Beach Pundit

3) Eurozone Slowly Healing its Wounds: The Greek political and fiscal soap opera is grabbing all the headlines, but quietly in the background there are signs that the eurozone is slowly healing the wounds of the financial crisis. If you look at the 2-year borrowing costs of Europe’s troubled countries (ex-Greece), there is an unambiguous and beneficial decline. There is no doubt that Spain and Italy play a larger role than Portugal and Ireland, but at least some seeds of change have been planted for optimism.

Source: Calafia Beach Pundit

4) Record Corporate Profits: Investors are not the only people reading uncertain newspaper headlines and watching CNBC business television. CEOs are reading the same gloomy sensationalistic stories, and as a result, corporations have been cautious about dipping their short arms into their deep pockets. Significant expense reductions and a reluctance to hire have led to record profits and cash hoards. As evidenced by the chart below, profits continue to rise, and these earnings are being applied to shareholder friendly uses like dividends, share buybacks, and accretive acquisitions.

Source: Yardeni.com

5) Attractive Valuations (Pricing): We have already explored the lofty prices surrounding bonds and $30 pepperoni pizzas, but counter-intuitively, stock prices are trading at a discount to historical norms, despite record low interest rates. All else equal, an investor should pay higher prices for stocks when interest rates are at a record low (and vice versa), but currently we are seeing the opposite dynamic occur.

Source: Calafia Beach Pundit

Even though the financial markets may look, smell, and taste like an anchovy pizza, the price, value, and return benefits may outweigh the fishy odor. And guess what…anchovies are versatile. If you don’t like them on your pizza, you can always take them off and put them on your Caesar salad or use them for bait the next time you go fishing. The gloom-filled headlines haven’t been spectacular, but if they were, the return opportunities would be drastically reduced. Therefore you are much better off by following investor legend Warren Buffett’s advice, which is to “buy fear and sell greed.”

Investing has never been more difficult with record low interest rates, and it has also never been more important. Excluding a small minority of late retirees and wealthy individuals, efficiently investing your retirement dollars has become even more critical. The safety nets of Social Security and Medicare are likely to be crippled, which will require better and more prudent investing by individuals. Inflation relating to food, energy, healthcare, gasoline, and entertainment is dramatically eroding peoples’ nest eggs.

Digesting a pepperoni pizza may sound like the most popular and best option given the gloomy headlines and uncertain outlook, but if you do not want financial heartburn you may consider alternative choices. Like the healthier and less loved anchovy pizza, a more attractively valued strategy based on a broadly diversified portfolio across asset class, size, geography, and style may be the best financial choice to satiate your long-term financial goals.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.